Alpha Moguls | Why Tamohara Investment Says Cash Flow Is Key To Pick Value Stocks

Tamohara is a firm that we founded around five years back. It’s been founded by people who were working in the capital markets for the last 20 years or so. So, this firm is primarily funded by people who work in the equity market. Some of them put in their capital and the others decided to come together and join this firm. That’s how Tamohara was founded.

There were three-four underlying principles on which we wanted to set up this firm. We wanted to be a platform-neutral firm. That means as an investment house, usually, people differentiate between the kind of research these platforms have. So, mutual funds, portfolio management services and alternative investment funds have different research methods. But we don’t believe in that. Investment processes and their philosophies are the same. The strategies might differ a little bit. So, broadly we said we wanted to be a firm that is built around a particular philosophy of investment and we will run with the PMS licence because that’s was the available alternative.

But we can run and advise on money for institutions, be they domestic or overseas. We said that we will be a house which is totally bottoms up. We want to build products that have “capacitised” and are based on risk-adjusted returns. So, usually, we see funds that become extremely large and when you have to move positions and give back money to clients, it becomes very difficult. (Hence), we said we will build “capacitised” funds where the focus of the money manager is not earning money through large AUMs, but rather it is to make money for his clients and then take a part of the profit share. So that in a way aligns the interest of the client with that of the portfolio manager.

I am not saying that handling large amounts of money is wrong because the business objectives of those firms are different from what we wanted to do as a boutique investment house. We also decided that we wanted to build portfolios around companies that were long-term sustainable businesses. A lot of people have talked about moats. Sometimes, there are these great compounders that you find, and you own them for years. But also, there are these businesses that have great moats but are going through problems because of microeconomic reasons or because of the fact that the management has not performed well. The management changes.

So, we broadly classify the investment style into three kinds of companies where we want to invest in: the steady compounders, the companies who are great businesses but are going through a cycle for some reason or the other and sometimes a catalyst comes into the business and changes it.

So, the first thing that happened when all the employees got together was deciding how to match the investment styles, because we were three money managers from different backgrounds. The issue was deciding on specific investment styles. Somebody is going to say we add , somebody will say we grow at a reasonable price, another will suggest adding growth. And now, everybody talks about buying quality at any price.

So, we decided to sit down and discuss what we are going to do about it and what Tamohara will stand for as an investment house. So, we thought let’s get back to the basics and reflect on what does and doesn’t work in India. Additionally, we could get ideas from whatever we had read about the great investment gurus. What do they talk about and how do they invest?

So, we realised that India had got a highly volatile micro (environment). People usually don’t read into it much. They think it’s a cycle, where one buys stocks at their peak, sell when they’re (at their low point) and get away with it. But the problem which is fundamentally there is that why are we volatile micro? We are a volatile micro because we are an energy deficient country. Yes, there has been a lot of talk about alternative fuels, but India’s energy intensity is going to increase in the next 15-20 years. We need to be aware that we need to import energy. This means that we have a deteriorating current balance; we have a situation where the fiscal side adds volatility in our economic growth.

We are a country in which high inflation very easily moves towards the physical assets, so gold has always been a large import. Lower inflation has now seen that gold and real estate have not received that money, but it is always natural for the common person on the ground to feel safer putting money into gold.

Third, we have not been manufacturing in a big way. So, today electronics are the second-largest imports in India. A changing microeconomic environment also means that the companies go through difficulties. Therefore, we basically look at the fact that in good times, you get debt and equity very easily in the market. Banks tend to lend money to you. Private equity comes, you do an IPO, you get equity. But in bad times, you don’t get that. And if you are a company relying on third-party capital to a very large extent, then in growth periods you grow but in bad periods you get into the debt trap or you go into a growth trap. So, for us, our focus came back when we said we wanted to buy companies where there is cash flow.

Not for all, but for the majority of times. And what kind of matrix should we look at? We said we should look at companies that turn a large amount of operating profits into operating cash flows and are not dependent on third-party funding either on debt or on equity.

Most of the companies should be able to generate enough return-on-capital to have a lower working cycle in order to have a positive operating cash flow. But we also wanted the larger companies and the mid-sized larger companies should have free cash flows. That means after they do their capital expenditure, they should have some amount of money left. Our belief is, when people look at it, dividends are paid from free cash flows, they are not paid from profits. For smaller size companies, we don’t mind that they reinvest most of their operating cash flows as they are growing at a higher rate, but they are not extremely leveraged. So, this philosophy works beautifully in the sense that markets are extremely volatile, and equity as a class is volatile. So, the annual volatility in a bond fund would be something like 6-7 percent in a long duration bond fund. In FDs, it is almost zero because the interest rate doesn’t change. But in equity in Nifty, it is 25 percent from what I know. So, you are supposed to compound money over a period of the cycle. If you need to do that, then what do you do? You have to fall less when the markets fall. You don’t have to be number one to know when they are rising. But you definitely need to be number one when markets are falling. The less you fall, the more you will compound over a period of the life cycle.

So, that’s the reason why we think that looking at companies that have cash flows leads to the fact that downsides are lower, and you compound money better. At the end of the day, investors are here for compounding. So, if there is a risk-free rate of return or the fixed income return is 6-7 percent, you should be happy today in the new framework of low inflation of 12-13 percent. That’s how we normally work at lower GDP plus inflation. Then you add your alpha on that.

But, who follows this and how does this tie up? It all led to the master, Mr. Munger. So, Charlie Munger very famously says that if you get a 6 percent ROIC business at a discount, then you should not be buying it. This will compound at that. If you get an 18 percent ROIC business at a premium, you should be buying it. But then the trick is to get into the better business. Optically, a lot of businesses can show higher ROIC. So, the trick is to get into the better business and hence, you should have a very strong research process that gets you there.

See, we run a screener initially on all the companies. It’s market cap-agnostic, benchmark-agnostic and sector-agnostic. What you try to do is try to see whether these companies are growing at a reasonable rate and in line with nominal GDP. The initial screeners have to see that these companies are converting at least 40 percent of their operating profits into operating cash flows. So, we don’t want companies that don’t convert it. Because at any point in time you will lose money in them. For larger companies, they should convert at least 40 percent of their operating cash flows into free cash flows. On the other hand, for smaller companies, we are okay if they don’t.

We see that the debt-to-Ebitda should not be more than 4, it should not be highly leveraged. We are okay if it’s leveraged, but not highly leveraged. (Further), the last three year’s ROIC (return on invested capital) should be 70 percent of at least six years of ROIC, just a screener. This is not decision making. This is followed by a detailed research process.

In the research process, we initially run a screener and we get 100 companies. Initially, we had companies with a market cap of about Rs 600 crore and even with a market cap of one-and-half lakh crore. We have a team of eight people right now, we are four portfolio managers. What is unique is our portfolio managers also do research. So, very early in my career, I worked with Quantum Asset Management and there was a rule over there that all portfolio managers have to cover companies. You can’t sit in your ivory towers and take decisions. You can’t outsource that activity. So, we create a buddy system. We are sector-agnostic. Our research analysts are also sector-agnostic, so we don’t put them in sectors because their focus becomes narrow. If everything in pharmaceuticals is ‘Buy’, for example, it’s a relative ‘Buy’. But when you are in the business of absolute, you need to know whether you’d like to buy a bank stock, versus an FMCG stock or a consumer stock.

So, we create a buddy system and give these 100 companies across the eight of us and the first part of the research process is to look at whether this business will grow. And if it does grow, will it be profitable or not? So, we did see growth in telecom in the last 10 years but found it was not profitable. When the intense competition came into 2008-09, rates in prepaid were cut from Rs 2 to 20 paisa and now they are bundle rates. The ROIC permit was negative on these businesses. So, the growth didn’t help.

We need to know if it is profitable, is there an advantage if you sell a better product? The cost optimisation, what kind of supply chain do you have and what kind of working capital cycle do you have and what kind of distributions do you have? And we try to look at the listed and unlisted companies. This is the initial part. Does this company has the ability to remain number one or two or can become number one or two? So, for example, Asian Paints has continued to be number one but if you come to a segment which is only about plastic pipes (just as an example), an Astral Poly 10 years back was nowhere near a Supreme, but technically today, from a positioning perspective, an Astral Poly is number one. So you would want to get into those companies.

So, this is the first level of screening that we do. The second level of screening that we look at is we put 10-year numbers, the objective is not to look at CAGR, it is to look at where these numbers come from. So, if a company is doing at 12-13 percent, is it because the industry is growing like that? Is this because the company is growing a little bit higher or lower? Why is it growing that way? Is it getting into your market? Is it doing something different? We need to see if the company is a leader or not.

Generally, good companies, especially in India where the working environment is very difficult (you need massive numbers of regulatory approvals, competition is very high, you have a lot of state laws and central laws you need to follow) tend to do better in these environments. So, the old saying, “When the going gets tough, the tough gets going”. So, usually, you are able to differentiate. We don’t like to buy businesses where there is a forced mature kind of a situation. For example, if some country stops production and growth/profits go up over a period of time, then you jump into the bandwagon saying that, “Oh! Now the rates are going to be up.” But that is not sustainable.

So, if you want to buy long-term sustainable businesses, your assumptions on your profitability cannot be because of some closure but have to be because of the fact that the company is doing something better and is optimising something over a period of time. We also look at the fact that how the manufacturing process works actually in the company. We look at how the allocation is, the capital allocation is and from where the cash flow comes through.

The third part is where you identify the multi-baggers where you go on the ground and meet a lot of companies. It is not just about the historical numbers. The historical numbers indicate whether the capital allocation the company has been trying to optimise in a 10-year cycle gives you enough evidence. When people say that we are buying long-term sustainable, good management businesses, if you pick up the balance sheets and then the management will go wrong but if they have corrected their business, if they have tried to optimise things in their businesses, you know it is a decent business. They might not be creating cash flow right now, but in the next three-four years, they might create substantial cash flow. That’s where stage three comes where we spend a lot of time on the ground. So, early in my career, when I just used to go and meet management in their office. But a decade back, I realised the fact that we need to be on the ground.

So, every analyst is mandated to spend at least 50-60 days on the ground. One takes a car, gets out, meets listed and unlisted players, ex-employees, suppliers, distributors. We also do third-party forensic checks on all companies we invest in. The analyst then comes and offers advice on what he thinks the company should have been doing. Then we do a five-year forecast. The reason we do a five-year forecast  is that a two-year forecast is explicit, three years is implicit, and everything comes back to averages due to the normalisation of earnings. In good periods, analysts tend to over-forecast. Conversely, in bad periods they under-forecast. That’s the reason why you have bull and bear market rallies.

So, the normalisation of earnings allows us to understand that if ceteris paribus a business grows at a certain rate, then the operating and fixed leverage of a business and the way the management wants to optimise a business will create this kind of cash flow.

Our belief is that when companies start to create free cash flows and they become rerated, then investors see that dividends are going to come to them in the future. So, that’s broadly how we identify. For example, we saw a chemical company called Vinati Organics four years ago and examined its balance sheet. We could see through the balance sheet that it had never done any bad capital allocation and had moved up the chain. It was a very small company of around Rs 400-500 crore market capitalisation (or even less). We went and did a 360-degree survey.  We figured out that the mature part of the business had lower ROIC, but the newer products had a much higher return on invested capital. We went and met competitors and buyers of their products and got very good feedback about them. The promoter managers don’t meet at all, but we still tried to get a sense of how these people are. We were really invested in that firm. If my process ticks 80-85 percent of all the boxes, and there are no issues of any money moving out of the balance sheet. And people don’t tend to read balance sheets. Hence, the focus is on cash flows. If something is not happening in the profit and loss statement, the impact will be on the balance sheet, the cash flow statement will catch it. So, if you are generating profits at 30 percent CAGR, but the cash flow and operating levels are not growing, or post-fixed assets are not growing in line or higher, then there is some problem in the business if it’s not being re-invested. And Vinati then went on to be a multi-bagger.

So, there have been multiple instances in these kinds of companies. For example, in the case of banks, let’s look at a very boring bank like City Union Bank, which no one wants to look at, but what we saw was very consistent on the kind of business it did and very focused on asset quality. In the lending business, lending is very easy but recovery is very difficult. So, we like managers who control their asset quality and price the risk in their business. Funnily, in the last 10 years, it has apparently delivered more returns on a CAGR basis than HDFC bank has. It has good, conservative management. Such businesses are out there and there are enough of them.

So, three years back, nobody wanted to touch Nestle. The management changed and we thought Nestle was a great brand and good business. These businesses have very good modes and it’s not easy to replace their products. So, we invested in their business and also saw a change in the way their management was doing business. So, between 2006 and 2010, they were a volume-focused business. We have an internal metric which says that if prices are ceteris paribus, then we should grow at 10-12 percent. Between 2010 and 2015, the focus changed to pricing. And usually, when you do something wrong, wrong things happen to your business. So, even Maggi happened in 2015.

So, 2016 was a great year for you to buy Nestle, new managers came in and said they will focus on volumes. The consensus was that pricing was not going to go up and margins will fall. But operating leverage played out and stock price performance is history. Therefore, focusing on this gives you enough opportunities. Since we run a concise portfolio, we don’t cover a lot of companies, just 70-80 of them. We are not in the problem of creating a portfolio of 60-70 stocks. So, you do your work well, show conviction and determine if you are going to buy a larger position. One must not buy more than 10 percent in a portfolio when there are larger positions involved on an average in a mutual fund. You then convert that into longer-term holdings and create Alpha.

Oil-marketing companies have had this problem of the fact that they are majorly government-owned, but there are a few marketing firms. These are now private, but they were closed in between for a period of time. They have a problem with subsidies coming into the balance sheets. They are not bad businesses, but the view is that managements change really often, there is government interference in the pricing of the product. So, according to me, they are not moats. Yes, if they were purely-private and pricing was free and there was proper infrastructure, then they would have been big moats. So, the reason we don’t invest in these businesses if because of that. They are cyclical and we tend to stay away from them. Wherever we have high regulatory interference or government interference, we tend to stay away from them.

Coming to exhibition. Yes, I believe they are very big moat businesses. I have, in the past, owned PVR in a big way. If you have the right catchment area; the advantage the leader has versus the others is where the property is based. They were very strong in the north and the west. This is just for example since I don’t own the stock anymore. They had the right areas in Bombay and the right acquisitions in Delhi. They built their business quite well. If you have the right catchment area, then Bombay and metro cities are very populated. They have also had a policy of setting up a catchment area every 4-6 kilometers in populous suburbs. They have the ability to convert eyeballs into advertising. A third very controversial topic was that the F&B margins were extremely high. That has played out to a large extent. Seven-eight years back, you couldn’t see ROIC on the balance sheet. That’s when you drill down and see that the screen ROIC was higher, but the balance sheet ROIC was not. They were investing and one had to adjust for the capital investments happening in the business. You could see that they could make a 20 percent-plus return on the screen basis, and as the operating leverage plays out better. But what’s happening now is the invasion of online content. We have seen that though people talk a lot about broadband penetration, the U.S. doesn’t have that high broadband penetration. Even South Korea has a higher one than the U.S.  So, this will be the difference, and we will have premium services coming up.

People now are consuming better products and are building their dens, which have got their private viewing places. We still think as an entertainment format, films will continue to do well. The U.S. markets are indicative of that. People still go to cinema halls and the way they are made, and the way exhibitors are creating properties, people will pay money as a premium to go for entertainment. The reason this has worked in India is that in the smaller cities, there is no alternative to the cinema. There are no rock concerts or plays. So, for a lot of people, going to cinema halls is a normal thing. Yes, there is volatility in content. But good players can, in the long-term, make sustainable money out there. I think it’s a very strong moat. Stocks tend to perform in shorter periods of time. But exhibitors have given very good performance in the last 10 years and in the next 10 years, they’ll continue to do that.

So, there are some very strong moats. The first two players right now are the major challengers. We have seen the third and fourth players almost disappear. There is a new third player in the segment. You have PVR, Inox, Cinepolis, and Carnival. Carnival is in the lower player. PVR and Inox are clearly leaders and they are very strong moats. And they’ll continue to do well. The moats are not going to disappear.

I think in financials, the most important part, as I was saying earlier, is that lending money is the easiest part. Recovering money is the more difficult bit. For growth, you need to lend across the spectrum. That means the risk-adjusted pricing of your products has to be there. A few of them who have demonstrated that over a period of time have done well and a lot of people have tried to follow that model. HDFC Bank was the first one to do that. The moat for HDFC is its ability to say that in a given cycle, this is my loss-driven default rate, these are the number of NPAs I have and, therefore, I will price the product at this level. In good times my provisioning is less, so I’ll provide extra and in bad times, my provisioning is going to be higher, so I’ll take the money out and put it over there. And hence, the consistent 20 percent profit growth number is delivered.

Second is product innovation and technology. The key to any lending business is asset quality control. So, you have to be brilliant in technology and at reducing cost and the top ones have done that. The moat is actually in how you price it. I think Kotak has done that very well. In the NBFC space, Sundaram Finance in the last 25 years has done it extremely well. So, if you don’t price your risk properly and do unbridled lending only for growth, then you don’t get out at the right time and there’s a problem. So, whenever these companies have seen a problem in their individual segments, they have cut down lending. Whenever they have seen irrational competition, they have cut down lending. Let’s look at Bajaj Finance, which is a market leader. I remember meeting Rajiv Jain in 2012-13, the gentleman who runs the company, they were big in the lab. But Jain said he was getting out of lab then. This was way ahead of the market because lab yields had fallen. They had huge technology and data analytics, but also the sense that when the pricing is wrong, one has to get out.

So, the market is large enough. As HDFC’s Mr. Puri says, “Why do guys keep asking me about growth because there is enough potential?” It’s what you need to pick and choose and the philosophy behind it. How do you go about it and what’s the strategy behind it? And I think the pricing is very important. That’s the moat. Everyone is replicating the technology out there, with some replicating it better than others. But the top guys are doing it extremely well.

I am very happy that India has a 4.5 percent GDP. In these times, it’s very clear that averages and normalisation will happen in the economy. It’s happened in 2001-2003, 2011-2013. GDP has gone back to averages. Now the new GDP, according to my calculation, is 7.75 percent. In Q1 of the last financial year, it was 8 percent. So even if it is 6.5 percent in the old series, that means economic activity and earnings pick up. So, we think that the broader market should do better. Now whether it will take 12 or 16 months for that to happen is something which I cannot time. With a three-year period, I’m quite sure that GDP will go back to that 8 percent level on a new series. This means a lot of small and mid-sized companies—which are good quality, where price correction is not because of the deteriorating earnings, or cash flows, but more because of liquidity in those companies—should be bought right now.

So, as a bottom-up house, we are not looking at themes, but rather companies that can do well. India is a consumer-oriented economy. Even a consumer bank is a consumer bank. A lot of companies more on the infrastructure rather than the engineering side will do well. These are product companies, essentially. There is a lot of activity out there.

We, as a house, avoid pure infrastructure since we do get worried about government regulations. Good companies get damaged and we have burnt our fingers out there in the past. So, we will wait and watch over there. But broadly we think, a large part of the market will do well. Some of the sectors are beaten up and down, like autos and stuff. If we think there’s out there, if 4.5 percent moves up, we’ll go there. We have been participating more in the MNC pharma side and the larger corporate banks. It’s where we thematically thought we’d make money, which we have done over the last 18 months, but we think the broad market should do better. It’ll take us some time before the GDP moves up, but at 4.5 percent, I don’t want to buy the ones which are just bought for quality, but actually those at a reasonable valuation, which have cash flow. We’ll deliver better cash flow on average economic growth. That’s broadly what we think over the next 24-36 months.